This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

The Ins and Outs of SERP Swaps

Preserving the wealth in supplemental retirement plans.

WHILE NONQUALIFIED SUPPLEMENTAL
EXECUTIVE retirement plans (SERPs)
are a tax-efficient way to restore benefits lost
due to the limits in IRC sections 415 and
401(a)(17), they are not the best way to
transfer wealth to the next generation. Multiple
taxation and lost earnings can erode up to 85
cents of every SERP dollar transferred to an
executive’s descendants.

TO HELP EXECUTIVES MAXIMIZE WEALTH FOR
FUTURE generations, some companies
offer SERP swaps. Executives can swap heavily
taxed retirement benefits for tax-favored
employer-funded life insurance contracts on the
life of the executive or the executive and his
or her spouse.

IF AN EXECUTIVE DECIDES TO SWAP EXCESS
retirement benefits, the company spends
its cost savings on annual premiums for a
split-dollar insurance policy. To keep the
insurance proceeds tax-free, the executive
assigns the policy to an irrevocable trust. 0

A SWAP CREATES NO ADDITIONAL NET PRESENT
VALUE to the company. The exchange
also eliminates accrued and future compensation
expenses, boosting net income and reducing
required proxy disclosures. A company will also
have to make certain financial reporting changes
to account for the transaction.

TAX-WISE, THE ADVANTAGES OF A SWAP FOR
the executive depend on whether or not
the exchange triggers income taxation of the
SERP benefit or if the IRS changes its position
on the taxation of split-dollar life insurance.
Using an insurance trust will create gift and
possibly generation-skipping tax consequences
that an executive should consider carefully
before swapping.

JOHN C. BOMA, CPA, is a senior
vice-president in the Minneapolis office of Mullin
Consulting, Inc. He is a member of the AICPA task
force on employee benefit taxation. His e-mail
address is johnbo@mullinconsulting.com
. JUSTIN D. TONEY is a senior associate in the
Los Angeles office of Mullin Consulting. His e-mail
address is justint@mullinconsulting.com
.

As Congress has
continued to lower qualified plan limits, SERPs have become
an increasingly important part of a corporate executive’s
wealth accumulation strategy. Today, it’s common for more
than 80% of an executive’s retirement benefits to be
delivered through nonqualified plans.

Despite the
benefits, many executives with sufficient retirement income
are concerned about the tax inefficiency of SERPs as a
wealth transfer vehicle. Multiple taxation and lost earnings
can erode up to 85 cents of every dollar of SERP income
transferred to an executive’s descendants. These taxes often
include:

Income tax at receipt of SERP
benefits.

Income and capital gains taxes as assets accumulate
following retirement.

Many
companies are implementing programs to help executives with
this tax planning problem. One approach to maximize wealth
for future generations and create liquidity to pay estate
taxes is called a “SERP swap.” Also known as a preservation
of wealth plan, a benefit exchange or an excess benefit
swap, the arrangement allows participants to exchange
heavily taxed retirement benefits for employer-funded life
insurance contracts. The favorable tax treatment of life
insurance can help produce significantly more wealth for
future generations.

Multiple Taxation Cuts Into
Retirement Benefits

Taxes can consume
83% of assets and future growth

A SERP swap is a
complicated financial, tax and accounting strategy.
Experienced practitioners must help clients determine what
benefits to exchange, plan mechanics and the optimal life
insurance arrangement. It’s also important for financial
managers to understand how these arrangements work so they
can help their employers assess the consequences of offering
SERP swaps to the company’s key executives.

THE PLAN MECHANICS

An executive’s financial
position will determine the advisibility of his or her
participation in a swap. A participant must be able to
maintain a comfortable retirement without the entire SERP,
since the decision to forfeit benefits is irrevocable.
Companies often designate these income sources as eligible
for a possible exchange:

Deferred
compensation balances.

Accrued SERP pension benefit obligations.

Stock option gains and restricted stock.

Future salary and bonus.

Directors’ fees.

To execute a
swap, the company would structure a plan whereby a
participant agrees—in any year before retirement—to forfeit
all or a portion of future benefits. The company can spend
its subsequent cost savings on annual insurance premiums,
creating a cost-neutral transaction. A split-dollar
agreement between the two parties divides ownership of the
policy’s cash value and death proceeds. (Under most
split-dollar insurance arrangements, when the employee dies
the company receives an amount equal to the premiums it
advanced; the employee’s beneficiary receives the remaining
death benefit.) Participants generally assign their policy
interest to an irrevocable trust to isolate death proceeds
from estate taxes. Exhibit
1 shows the steps in a sample SERP swap.

Benefits to executive. A SERP swap
facilitates the participant’s exchange of otherwise taxable
income for tax-free insurance proceeds. The split-dollar
arrangement with a trust minimizes gift and GST taxes,
providing considerable leverage in transferring assets to
future generations. Beneficiaries will get between 2 and 10
times more inheritance from the insurance proceeds than from
the SERP. Exhibit
2 shows the results of a swap from the participant’s
perspective.

Benefits to company. A SERP swap is
structured to create no additional net present value cost to
the company. The exchange also eliminates accrued and future
compensation expenses, boosting net income, sometimes
considerably, in the first and subsequent years. The
reduction in compensation can also reduce proxy disclosures
for corporate officers. Finally, the company should enjoy
increased retention of top managers by offering a highly
regarded benefit. Exhibit
3 shows the swap results from the company’s
perspective.

Example. Mary Smith is a 50-year-old
executive with a large company. After doing some retirement
planning with her CPA, Mary decides she has accumulated
enough deferred compensation that she probably will not need
all of it for retirement income. She arranges with her
company to swap $500,000 of her deferred compensation as
well as $50,000 of her annual bonuses for the next five
years.

After calculating its future cost savings and
discounting it to a net present value, Mary’s company buys
$9.5 million of survivorship life insurance on the lives of
Mary and her husband. The company pays five annual premiums
of $378,000 and retains the right to an equivalent share of
the policy proceeds until Mary’s retirement. At retirement,
Mary’s trust (the policy owner) withdraws money from the
policy to reimburse the company for the premiums it paid.
The entire transaction is projected to cost the same as the
benefits Mary forfeited.

Before retirement, Mary
makes an annual contribution to the plan, via a gift to the
trust, equal to the pure insurance cost of her death benefit
coverage. After Mary’s trust reimburses her employer upon
her retirement, the trust holds the policy until both she
and her spouse pass away. Assuming the policy cash values
earn 8% annually and Mary and her spouse die at their life
expectancy, the trust will receive—free of income and estate
taxes—$20.6 million of death proceeds for Mary’s children.
The deferred compensation would have provided only $3.1
million to Mary’s heirs after payment of all income, capital
gains and transfer taxes (using the same 8% growth rate). As
a result, the transaction will create an additional $17.5
million in wealth from tax savings.

Exhibit
4 summarizes the advantages and disadvantages of a
SERP swap to both the participant and the company.

THE OPTIMAL INSURANCE ARRANGEMENT

Participants can choose
from among many different types of insurance policies for a
SERP swap, including general and separate account, single
life and second-to-die (survivorship) and “street” and
proprietary products.

General and separate account.
General account life insurance invests
policyholder cash values in the insurance carrier’s general
asset portfolio. Policyholders earn a relatively safe,
bond-like return and are general creditors of the insurance
company. Many carriers also maintain a segregated asset
account for variable, or “separate account,” policyholder
cash values. The separate account includes numerous
subaccounts, or investment portfolios run by professional
money managers. While the cash values are insulated from the
carrier’s general creditors, policyholders assume the
investment risk of their chosen asset allocation. SERP swaps
are typically funded with variable life insurance, since
executives tend to want more control over the investment
risk and asset allocation.

Single life and survivorship. A
married SERP swap participant may choose to insure his or
her spouse’s life as well, to reduce the policy’s insurance
costs. In addition, death proceeds at the second death will
coincide with the largest estate transfer costs, providing
funds to help beneficiaries pay estate taxes on other
assets.

Proprietary insurance products. When
buying life insurance, executive and corporate insurance
buyers generally have superior purchasing power. A SERP swap
participant should be eligible for institutionally priced
products designed specifically for this market. These
products have lower insurance charges and lower loads than
off-the-shelf products sold to the mass market.

Funding strategy. Funding the
insurance contract at the maximum (seven-pay) premium level
enhances performance by minimizing annual mortality costs.
Depending on the participant’s age, this strategy usually
produces higher death proceeds at life expectancy. Maximum
funding also reduces (or eliminates) the company’s initial
accounting expense from the insurance purchase. An
appropriate insurance contract should have very high
first-year cash values and no surrender charge.

TAX CONSIDERATIONS

A SERP swap offers the
potential for significant tax savings. Likewise, the parties
should carefully consider the risks of adverse taxation.
Proper design can mitigate—and often eliminate—some of the
tax risks.

A participant’s economic advantage in a
SERP swap is predicated on two assumptions.

The exchange does not trigger income taxation of the
SERP benefit.

The IRS does not change its position on the taxation
of split-dollar life insurance.

Taxation of exchange. The IRS could
consider the benefit exchange a taxable event if it violates
the doctrines of constructive receipt, economic benefit or
assignment of income.

Constructive receipt. Under Treasury regulations
section 1.451-1(a), constructive receipt is triggered if the
SERP benefit is set aside for the employee or otherwise made
available for withdrawal at any time. Most practitioners
agree that an exchange does not give the executive the
option of “cashing out” the SERP. Case law supports the
tax-free exchange of one nonqualified benefit for another,
although the IRS has not ruled specifically on a SERP swap
exchange. [See Oates, 18 T.C. 570 (1952); Veit,
8 T.C. M919 (1949) and Martin, 96 T.C. 814
(1991).]

Economic benefit. The IRS might argue that the
exchange confers an economic benefit on the executive if he
or she subsequently enjoys non-forfeitable rights to a
secured benefit. [See Minor, 772 f.2d 1472 (9th
Cir. 1985) and revenue ruling 60-31.] It would seem,
however, that an unsecured promise to pay premiums would not
confer economic benefit.

The executive does
recognize a separate, annual economic benefit from the
company-paid insurance coverage until the agreement
terminates. This amount is measured using the lower of the
Treasury Department’s PS58 rates (US38 rates for a
survivorship policy) or the carrier’s published one-year
term insurance cost for standard risks.

Assignment of income. The executive would recognize
taxable income if the exchange directed the SERP income to a
third party. [See Hicks, 314 F.2d 180 (4th Cir.
1963).] It would appear, however, that the
assignment-of-income theory does not apply to a swap because
the SERP benefit is never paid to the executive or to his or
her trust. The participant can choose to pay tax on the
economic benefit or contribute it to the plan.

Taxation of split-dollar life insurance.
The benefits of some SERP swaps depend in part
on the IRS’s current position on the taxation of “equity”
split-dollar arrangements. The IRS established its position
in revenue ruling 64-328. Since this ruling almost 40 years
ago, the general tax treatment of split-dollar has not
changed, except in a few situations.

Equity split-dollar. The IRS issued technical
advice memorandum (TAM) 9604001 concerning the taxation of
equity split-dollar arrangements in 1996. “Equity” refers to
policy cash value growth owned by the employee (or a trust).
The TAM advised that the employee’s cash value represented
taxable income under IRC section 83. The specific facts of
this case led most practitioners to conclude that the TAM’s
reasoning would not apply to a properly drafted split-dollar
agreement.

Gift taxes. The annual economic benefit of
insurance coverage held in trust is a taxable gift from the
insured’s estate. Each donor may exclude the first $10,000
of every gift from tax annually and use an additional
lifetime exemption ($675,000 in 2000, increasing to $1
million by 2006). An employee may use the annual exclusion
provided the gifts are of a “present interest,” achieved by
the grantor giving trust beneficiaries so-called Crummey
rights of withdrawal. Thus it is often possible to exclude
from gift tax all economic benefit amounts in a SERP swap.
This is achieved only through proper plan and trust design,
administration and documentation.

GST taxes. A SERP swap participant may establish an
irrevocable trust for the sole benefit of grandchildren and
subsequent generations. In addition to gift tax, annual
economic benefit amounts are subject to an additional 55%
GST tax on amounts in excess of each transferor’s $1,030,000
GST exemption. Like the gift tax, the first $10,000 of GST
amounts are excluded before the transferor must use his or
her lifetime exemption (subject to additional restrictions).

Interest deduction proration rule. A company owning
cash value life insurance on the life of a “non-exempt”
person loses part of its annual interest deduction based on
the ratio of cash value to total interest expense under IRC
section 264(f). Since an executive’s spouse is non-exempt,
the proration rule applies to survivorship split-dollar
contracts. Although it is generally minimal, financial
managers should estimate the long-term impact of the
disallowance so the company remains cost-neutral.

ACCOUNTING CONSIDERATIONS

Companies should be
aware of certain financial reporting consequences to
offering SERP swaps to employees.

Settlement and curtailment of benefits.
When a SERP swap participant forfeits a
defined benefit pension, the employer is irrevocably
released from its obligation. Under FASB Statement no. 88,
Employers’ Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination
Benefits, the swap should result in a net gain or
loss associated with the obligation. The net gain or loss at
settlement or surrender will be based on the employer’s
specific situation. The settlement may require the company
to immediately recognize or annually amortize the net gain
or loss.

Reversal of deferred compensation liability.
When a swap participant forfeits an existing
deferred compensation balance, the company makes adjustments
to reverse the accrued deferred compensation liability under
APB Opinion no. 12, Omnibus Opinion—1967.
Additionally, the company reverses the corresponding
deferred tax asset carried on its books under FASB Statement
no. 109, Accounting for Income Taxes.

Eliminating a defined benefit or defined contribution
pension obligation generally creates net income (gain) at
the time of swap. The company will also enjoy a reduction in
future accrual expenses associated with the benefits that
are exchanged.

Insurance value. FASB Technical
Bulletin no. 85-4, Accounting for Purchases of Life
Insurance, says the company should report as an asset
the amount that can be realized under the insurance contract
as of the financial statement date. Further, changes in the
surrender value of the insurance contract are netted against
premiums paid for the period to determine the net expense or
income. The provisions of the split-dollar arrangement could
affect application of the bulletin.

Postretirement benefits. A SERP swap
plan design may include a postretirement annual bonus to the
employee to alleviate the economic benefit cost as well as
postretirement premium payments. Under FASB Statement no.
106, Employers’ Accounting for Postretirement Benefits
Other Than Pensions, the company must accrue for the
present value of both obligations before retirement.

A GOOD DEAL

A properly structured SERP swap can provide a
tax-efficient alternative to nonqualified benefits to
accommodate an executive’s wealth transfer strategy. The
swap introduces important financial, tax and accounting
considerations the company, potential participants and
outside advisers must evaluate. Practitioners must help
their clients evaluate the risks and design alternatives to
separate attractive SERP swaps from risky arrangements.
Financial managers must help their employers offer swaps
that will benefit employees without costing the company
additional money.

There are over 30 million small businesses in the U.S., and many of them are optimistic in their outlook. Are you familiar with the obstacles and opportunities they are facing? Test your small business acumen with this quiz sponsored by Chase Ink®.